Biotech's 5-Baggers

Over the past few years, biotech investors have experienced a lot of wild ups and downs. After the now seemingly distant cold spell of 2002, much of the sector went on an extended run along with the rest of the market. Since the end of 2002, the Nasdaq and the Nasdaq Biotech Index have both increased more than 40%, while the S&P 500 has gained 28%.

Even while the market has run sideways for much of 2004, many individual stocks have done quite well and far exceeded the returns of the indexes over the last couple of years. With that in mind, I set out to find the best-performing biotech stocks to learn from their success in order to help identify tomorrow's top performers.

As the biotech analyst for Motley Fool Rule Breakers, I'm naturally inclined to look around for the big gainers. If I were a baseball scout this would be akin to searching for the next Barry Bonds instead of the next Pete Rose. Home runs, not singles, is what the Rule Breaker philosophy is all about. I want the power-hitting biotech that is going to hit me a home run, which I think of as a 300%-500% return over a few years. I found a number of biotech companies that have given investors those kinds of returns since the end of 2002. I have selected eight of them that are particularly interesting and will discuss them over a series of three articles.

Back from the deadThe first group of companies we'll look at have all bounced back from very serious problems to reward contrarian investors who saw a gem where the rest of the market saw trash.

Companies can get hammered on legitimate problems with their businesses. However, if the problem is temporary, the stock can be picked up on the cheap when no one else wants to own it because they are fixated on the short-term bad news.

The three companies listed below had major problems within the past few years and all initially experienced stock declines of more than 85% as investors fled in terror. However, since that time, all three companies have rebounded strongly, producing returns of several hundred percent. Investors who did their due diligence and had the fortitude to take positions in these companies while everyone else was bailing out were richly rewarded.

Antegren to the rescueElan's (NYSE: ELN) stock was absolutely crushed in 2002. The share price was in the mid-$40s starting the year, and by that October it hit a low just above $1. Since then, however, the stock is up almost 2,000% and has gained nearly 800% since the end of 2002.

Stock drops of more than 90% tend to happen for good reasons, and in 2002 there were many reasons to be wary of Elan. We have to remember that this was the post-Enron era, and Elan was facing allegations of improper accounting regarding its numerous joint ventures. In that environment, even a hint of cooked books would send investors running. On top of that problem, the company had a crushing amount of debt, and there were legitimate concerns over the company's ability to meet its obligations.

Unfortunately, Elan's problems were not limited to financial matters. In January 2002, Elan and partner Wyeth (NYSE: WYE) terminated clinical development of a highly anticipated vaccine for the treatment of Alzheimer's disease because of severe side effects.

Despite all of those problems, Elan turned it around the past two years by taking actions such as selling off assets and working to clean up its balance sheet. But the driving force behind the company's revival was the earlier-than-expected emergence of Antegren for the treatment of multiple sclerosis. Antegren is partnered with BiogenIDEC (Nasdaq: BIIB) , a biotech company that is a clear leader in the multiple sclerosis field.

Data from a phase 2 trial was published in the New England Journal of Medicine in January 2003, and that information gave a hint of what was to come. The big boost came in February 2004 when Elan and Biogen IDEC announced that the Antegren BLA would be filed after only one year of patient treatment data from the phase 3 program.

This news was very well received; usually with multiple sclerosis drugs, the FDA wants two years of patient treatment data. Since this accelerated filing came at the request of the FDA, it was a strong signal that Antegren worked and would be approved. Also, the early filing means that Antegren would contribute to profit growth a year earlier than originally anticipated.

Waksal's revengeEveryone knows about ImClone Systems' (Nasdaq: IMCL) disaster. Along with Enron and WorldCom, ImClone is a poster child for corporate fraud. After the FDA rejected ImClone's cancer drug Erbitux in late 2001, the doo-doo really hit the fan as former CEO Sam Waksal made one bad move after another. On top of lying to investors about the extent of the FDA's concerns about the Erbitux trials, Waksal was also involved in insider trading. Ultimately he (and Martha Stewart) went to the Big House after pleading guilty to numerous charges, including securities fraud. With all of these events going on, ImClone's stock could not hold up, and it fell below $7 after starting 2002 over $40.

Despite getting turned down by the FDA on its first attempt, Erbitux was not dead in the water. However, not that many people were paying attention to that with more exciting stuff going on. If ImClone and U.S. partner Bristol-Myers Squibb (NYSE: BMY) could present clinical data that was scientifically rigorous and demonstrated that the drug had a clinical benefit, Erbitux could be resubmitted to the FDA.

Fortunately, ImClone's European partner, Merck KGaA, was conducting such a trial so that it could get Erbitux approved in Europe. Merck KGaA reported positive results from this trial at the American Society of Clinical Oncology (ASCO) meeting in June 2003. Using this data, ImClone and Bristol-Myers refiled with the FDA in August 2003, and Erbitux was approved in February 2004.

Erbitux's transition from failure to success story was the catalyst for increasing the value of ImClone's stock 400% since the end of 2002, handsomely rewarding investors who bet on Erbitux when no one wanted to touch this company.

Deep pipeline pays offSepracor (Nasdaq: SEPR) would probably like to forget 2002. Its stock was pummeled early that year when the company received a "not approvable" letter from the FDA in response to the NDA filing for the antihistamine Soltara. Soltara was touted as having a more rapid onset of action than Claritin, and it was widely anticipated that Soltara would be another blockbuster allergy drug alongside Claritin, Allegra, and Zyrtec.

When the Soltara program was sidelined, all of a sudden Sepracor's near-term revenue picture didn't look as rosy and the market became concerned about the company's considerable level of debt. As a result, the floor fell out from under the stock, with investors taking a 90% hit before the carnage was over in the fall of 2002.

As it turns out, Sepracor was down, but it certainly was not out. The company was not a one-trick pony that was dependent upon a single drug like Soltara. Sepracor already had one drug on the market, Xopenex, which gave it a shot in the arm by delivering sales of nearly $300 million in 2003.

In addition to Xopenex, Sepracor had another value driver on the horizon with the drug Estorra for the treatment of insomnia. The filing of the NDA for Estorra in January 2003 gave the company a clearly viable drug that could be on the market in a short amount of time. While Estorra was not immediately approved, Sepracor submitted additional data to the FDA and approval is expected imminently.

As a result of this progress, Sepracor's stock is up 1,000% from the low of 2002 and more than 350% from the end of that year. Sepracor is a great example of how the market's fixation on short-term problems can create opportunity for investors who can see the long-term big picture.

Concluding thoughtsElan, ImClone Systems, and Sepracor share a similar trait of successfully emerging from a distressed situation. Companies that get severely beaten down can generate tremendous returns for investors if the problems are resolved and the company can get back on track.

One caveat with this approach to investing is that it is far easier to identify these types of investments in hindsight. To invest in distressed companies in real time takes a lot of work and involves a lot of risk. There are many companies that fall down and never get up again. Companies with permanent problems are not good investments no matter how cheap the stock gets. The key to investing in these beaten-up companies is to determine if the problems are temporary and if the company has the ability to resolve the issues. This is exactly the kind of thing I spend my days studying as part of the Rule Breaker team.

Finding downtrodden biotech companies with ignored potential is not the only way to attain Rule Breaking returns. In my next two articles, I will go over another way that a handful of biotech companies have made investors quite happy. I hope you'll join me. And if you're in search of stocks with the potential for oversized returns, I hope you'll take a free trial to Motley Fool Rule Breakers so you can also see what David Gardner and the rest of our team are up to.

Fool contributor andRule Breakersanalyst Charly Travers does not own shares of any company mentioned in this article. The Fool has adisclosure policy.

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